Sales Tax on the Internet: Who Pays It, Who Doesn't

Here's the skinny on Internet sales tax.

The Internet takes tax-free shopping to a new level. In fact, no-tax shopping has become a prime lure of online retailers looking to hook consumers on click-and-charge buying. Despite what you sometimes hear, however, some Internet sales are subject to sales tax, and even when a site doesn't collect sales tax, consumers are technically responsible for remitting any unpaid sales tax on online purchases directly to their state.

Collecting Sales Tax: Some Sites Have To, Some Don't

If an online retailer has a physical presence in a particular state, such as business offices or a warehouse, it must collect sales tax from customers in that state. If a business does not have a physical presence in a state, it is not required to collect sales tax for sales from customers in that state.

How Big Sites Avoid Charging Sales Tax

Some big retailers with local stores can sell their products tax-free over the Internet because they have established separate legal subsidiaries to handle Internet business. For example, the Barnes & Noble website that you buy a book from online is a different company from Barnes & Noble at the mall. If the online Barnes & Noble doesn't have a physical presence in a certain state, such as business offices or a warehouse, no sales tax is charged for online purchases to customers in that state. The practice of establishing a separate legal entity principally to avoid sales taxes has raised the ire of thousands of brick-and-mortar retailers whose customers must still pay tax.

The issue becomes even stickier when a company's online and offline entities experience some customer interaction. For example, a consumer buys tax-free golf clubs from Wal-Mart.com but is allowed to return them offline to the local Wal-Mart store. Whether such entities are legally independent of each other is a matter that has not been tested in the courts.

Consumers' Responsibility to Pay Sales or Use Taxes

Consumers who live in a state that collects sales tax are technically required to pay the tax to the state even when an Internet retailer doesn't collect it. When consumers are required to pay tax directly to the state, it is referred to as "use" tax rather than sales tax.

The only difference between sales and use tax is which person -- the seller or the buyer -- pays the state. Theoretically, use taxes are just a backup plan to make sure that the state collects revenue on every taxable item that is purchased within its borders. But because collecting use tax on smaller purchases is so much trouble, states have traditionally attempted to collect a use tax only on big-ticket items that require licenses, such as cars and boats.

Some states, including Connecticut, Maine, Nebraska, New Jersey, and North Carolina, have changed their attitudes and are stepping up efforts to collect use taxes. But bureaucracy, complex tax rules, and limited state resources have thus far prevented most states from pursuing use taxes. Since state governments are losing substantial revenue, the collection of use taxes may become a priority if the federal government continues its ban on Internet e-commerce taxes.

The Internet's Future as a Tax-Free Zone

Will Internet purchases remain tax-free? We'll find out in coming years as Congress and state legislatures wrestle with this issue. In 1998, Congress passed the Internet Tax Freedom Act (ITFA), which established a three-year moratorium on taxing Internet access services at the state or local level. And in December 2001, President Bush signed a two-year extension of the Internet sales tax ban. That extension expired in 2003, and as of December 2004, has not been renewed. Regardless of whether the ban is made permanent, as some in Congress are seeking, the basic rules regarding sales tax continue to apply -- collection of sales tax for items sold over the Internet is only required if a business has a physical presence in the state.

Naturally, there is a great deal of opposition to this tax moratorium from state governments and brick-and-mortar retailers. A look at the numbers explains why. Sales tax revenues currently amount to about $150 billion annually and make up approximately one-third of all state revenues. These taxes pay for everything from schools and police to roads, parks, and other state services. California, alone, estimated losses of over a billion dollars per year.

States that don't have a personal income tax, like Texas, are even more dependent on sales tax revenue. (The five states that don't have a sales tax -- Alaska, Delaware, Montana, New Hampshire, and Oregon -- aren't hurt at all).

In 2002, state governments organized to fight back. Under a state-led initiative known as the Streamlined Sales & Use Tax Agreement (SSUTA), 40 states and the District of Columbia banded together to simplify their sales tax codes in order to make sales tax collection easier. Under SSUTA, the collection of sales tax still remains voluntary. However, if ten states representing 20% of the U.S. population vote for the rules, the organization will pressure Washington D.C. for federal legislation. The SSUTA has gained traction recently. Several national retailers have negotiated with member states for amnesty deals in return for future collection of sales tax, and more are expected to follow. The SSUTA expects to implement a multistate arrangement effective October 1, 2005, and a number of states are preparing certificates of compliance with the SSUTA. In addition, several states have already amended their tax laws to conform to the SSUTA. With all of this pressure from states, many expert believe that within the next few years you'll be throwing a few more dollars into your shopping cart for state sales taxes.

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